Sometimes it is the first issue on the agenda when it comes to negotiating an investment in a startup or emerging company, and sometimes it's the last. No matter when it comes up in the process, there is no denying the overarching importance of the infamous "pre-money valuation" of the company.
Some may need a quick primer of valuation of a company raising a round of financing. Asking the question "What is the valuation?" is slightly off-base. It is more important to break it down and ask either "what is the 'pre-money' or 'post-money' valuation?"
Pre-money valuation as used in the midst of raising money for a company means the value of the company just prior to taking in investment money. It can be expressed as a total company valuation or a per-share or per-unit valuation.
For example, if you have 10 million outstanding shares of your company and you want to sell 1 million more shares at $0.10 (10 cents) each, then you are saying that the 10 million shares are worth $1 million on a pre-money basis. This is calculated by multiplying the $0.10 per share by the 10 million pre-money outstanding shares. Thus, the pre-money valuation of the company is $1 million.
In the example above, the "post-money" valuation would be the pre-money valuation times the total value of the money raised in the round, or $1
million plus $100,000, or $1.1 million.
Some simple formulae are:
Pre-Money Valuation = Outstanding Shares x Share Price
Post-Money Valuation = Pre-Money Valuation + Amount Raised
An entrepreneur seeking funds from investors with some degree of sophistication will face the question, "What is your pre-money valuation?" This is a pivotal moment in the negotiation.
Almost more than anywhere in our free enterprise system, the negotiation for early-stage investment is Wild West capitalism at its finest. It's highly subject to negotiation within the framework of the local economy and customs.
One of my favorite entrepreneurs and angel investors is Steve Gibson. He was a successful entrepreneur in Colorado before coming to Utah to teach at BYU's entrepreneurship program (he is currently teaching at BYU-Hawaii to help that school's program). Once in Utah, he became a prolific angel investor at the foundation of some of Utah's most exciting ventures, such as 1-800-CONTACTS and MyFamily (now The Generations Network). Steve says that "the most highly paid of all human activity is negotiating." How true that is! Skills in negotiation will reward handsomely the players in early-stage investing.
Bottom line: Brush up on your negotiating skills before becoming an entrepreneur. Nothing will pay bigger dividends.
What are the local customs along the Wasatch Front of Utah? Good question. They are in a state of flux with ever-increasing immigration of professionals from California and other states on both sides of the game. Overall, that is a good thing.
Typically, deals that I see follow these rules of thumb:
$300,000-800,000: Company is selling common stock and is pre-revenue (no sales).
$800,000-$1.2 million: Company is selling preferred stock and is pre-revenue (no sales).
$1.2-1.5 million: Preferred stock; revenue imminent or a trickle.
$1.5-2.5 million: Revenue ramping.
$2.5-$4.0 million: Revenue established; good track record; wrinkles ironed out.
In Utah, it's rare to see early stage investors invest at a pre-money valuation greater than $4 million because by that time it may be best to leave the investing to professional venture capital funds.Pre-money valuation is not the only topic of importance in the early-stage venture investing process, but the entrepreneur will find that understanding how it works will give him or her an edge up in securing those all-important investment dollars.
John E. Richards is associate director of the BYU Center for Entrepreneurship. He can be reached via e-mail at email@example.com.